Innovation Box Tax Reform Proposal

On July 29. 2015, the House Ways and Means Committee announced that some members had drafted a bill calling for an innovation box (aka patent box), similar to what is used in a few others countries, such as the UK. Chairman Ryan praised the bill as relevant to international tax reform and helping US companies be more competitive.

The proposal has two parts:

1. 71% deduction of the lesser of (a) “innovation box profit for the year” or (b) taxable income (without the deduction).

2. Provision to allow US companies to bring back to the US foreign intellectual property tax free.

While that may sound simple, the challenge will be in defining “innovation box profits.” That involves a few more definitions. It is not the definitions that will be most challenging, but identifying a company’s costs relevant to each definition.

“Innovation box profits” = “Tentative innovation profit” x a ratio comparing 5 years of US R&D to 5 years of total costs. It appears that the rationale for this ratio is to be sure this primarily benefits companies that engage in a lot of R&D. For example, if a company generated a lot of profit from a patent, but there was not significant R&D spent to create that, that company’s deduction would be reduced.

There is a lot more. I won’t go into to define “tentative innovation profit” but that will be the challenging area. It will be similar to calculating the Section 199 or DPAD deduction in that a company needs to identify its cost of sales and other expenses attributable to the innovation profits. That will be challenging and a key IRS examination area.

Observations:

• The proposal is a deduction rather than a lower rate on innovation profits. I note this because some of the explanatory information suggests the proposal is for a 10% rate rather than 35% rate on innovation profits, but the benefit instead is what I refer to as a “bonus” deduction in that it is not a cash outlay, but an extra deduction (similar to how the Section 199 deduction works).

• Given that R&D spending as a percentage of all spending factors in, why not just increase the research tax credit? That would be easier to calculate. If the research tax credit remains along with the innovation box, it will be more difficult for some companies to use the credit because their overall tax will already have been reduced due to the extra deduction.

• Why not reform the research credit by increasing the percentage, keeping only the simplified version of the credit, and allowing start-up companies to also use the credit against payroll taxes (since they might not have taxable income)? But still enact the part to encourage companies to bring their foreign IP to the US – and reform our system so that the tax rules don’t encourage developing IP outside of the US to start with.

• Perhaps the innovation box is offered because the OECD BEPS project suggests this regime is permissible in that it better matches value generation with taxation (see Q&A 19 – 21 from OECD). Also, per the bill sponsors: “The OECD BEPS project will soon require every innovation box to include a nexus component. In other words, a company will have to locate its research and development—and the high-paying jobs that go with it—in the country offering the special tax rate.” However, it seems that the research credit should also be fine in that it is for R&D in the US and will reduce your US taxes. If there are foreign profits from the R&D, they are taxed where generated (and in the US unless we also move to a territorial system).

• Why 71% and not 70%? Why not a different rate on the profits rather than a deduction? As a deduction, the issue arises as to the effect of the deduction creating a loss (negative taxable income). The proposal specifies that the innovation deduction is not considered in calculating an NOL (similar to the 199 deduction). And if a company has negative taxable income prior to measuring the deduction, there is no deduction because the lesser of (a) innovation box profit and (b) taxable income would be taxable income at zero. In contrast, a credit carries over if not usable in the year generated.

So, it is an interesting idea to have on the table as part of tax reform discussions. Perhaps it will help highlight a need to have a system that encourage more innovation in the US and the best design for the research credit. Let’s see what happens.

The sponsors are seeking comments on some specific questions including definitions and approaches for allocating expenses between the innovation profits and other sources.

Annette is the immediate past chair of the AICPA Individual Taxation Technical Resource Panel and a current member of the Executive Committee of the Tax Section of the California Bar. Annette is a regular contributor to the AICPA Tax Insider and Corporate Taxation Insider e-newsletters. She is the author of BNA Portfolio #533, Amortization of Intangibles.

Annette has testified before the House Ways & Means Committee, Senate Finance Committee, California Assembly Revenue & Taxation Committee, and tax reform commissions and committees on various aspects of federal and state tax reform.

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